Thursday, May 08, 2008

In a few months Lijit Networks will be two years old. We started the company in a fairly common way, finding employees that wanted that "ground zero" experience, having the seed of a good idea, and finding Angel Investors that would invest and keep the idea alive long enough to germinate. It wasn't easy but we got it done. A question I get a lot from new entrepreneurs is "how do you find Angel Investors?"

Many young startup entrepreneurs tend to look at Angel Investors as a group of people with more money than sense (which sometimes is true) but generally not. They give no thought to the motivations of their Angels, what their Angels should get from the relationship, or simply why the Angel should be interested in investing. Like anything, understanding your audience is half the battle. Don't trivialize your Angels Investment by rationalizing the money isn't important to them; I find that $25K is important to everyone.

I have been on both sides of the Angel Investment table. Lijit was Angel funded for the first year of its life. We raised approximately $900K from a combination of friends, family and seed professional investors. On the flip side I have made several Angel investments in other local companies – with varying success. Based on this sample set plus other random data I have collected along the way, I have established a basic way to look at Angel Financing.

Types of Angel Investors:

The Family Investor: The Family Investor is likely not really a classic Angel Investor at all but rather a supportive family member that "knows you". Their motivation is likely out of support (sometimes guilt), but their basic investment thesis is they trust you. For me these are the worst type of investor because you likely have intimate knowledge of their financial situation and whether or not they 'should' be investing. Likely, they have no inherent feel if your idea is good or not, but may have changed your diaper at one time or another and have overcome that experience to hand you a check for $25K or $50K. Personally, I like this category of investor the least because the investment is totally emotional and personal – and that sucks in business. But based on the financial situation of the individuals involved and the relationships this can work ok if everyone comes into the situation with their eyes open, but go out of your way to make sure.

The Relationship Investor: The Relationship Investor is probably one or more co-workers from a previous gig or business friends you have known for a while. They may or may not understand what your new company is doing but they have had a track record working with you. They want to be supportive, but are looking for a return. You won't lose them as friends if things go bad, but the investment for them is likely not 'trivial'. In my experience these are good Angels to have, again as long as their eyes are open going in. These people can also be wildly supportive of you in terms of finding employees and other resources.

The Idea Investor: The Idea Investor is probably very familiar with the space your company is targeting. These are in some ways the very best types of Angels because to some degree they validate your idea. There investment is based on the Idea and there is little emotion around the table (always good). If you can get them onboard they can open doors into partner relationships and just generally good advice. You will spend most of your time convincing the Idea Investor that you and team are the right people to attack this problem (as they likely don't have a strong relationship with you or the team). Often an influential Idea Investor makes a good early board member for the company.

The Once Removed Investor: The Once Removed Investor is likely connected through a personal or professional relationship with either the Relationship Investor or the Idea Investor. They likely don't know you, and they likely don't have a clue if your idea is good or bad but they have translated the trust in the investment to the person they know. This is a great way to get additional Angel Investors onboard, but without a solid Relationship Investor or Idea Investor it just isn't going to happen.

I personally have never seen an Angel Financing come together without some mix of the first three investor types plus a few Once Removed Investors. Be warned that the Once Removed category of investors will also supply the softest money in the upcoming financing. Simply put - as you verify amounts before close, the Once Removed guys are the ones that tend to "go away" or "get smaller" as the deal progresses. A friend of mine that has successfully financed several companies gave me the rule of thumb that most investors will end up being about half of what they initially committed to. This is definitely true of Once Removed Investors; I once had a $400K guy turn into $50K guy, and $50K was like pulling teeth.

Finally, there is a concept I refer to tongue-in-cheek as the Arc Angel. An Arc Angel is a Relationship Investor or Idea Investor that has a track record of success making other Angels (and perhaps non Angels) money. These people are valuable as they can be very influential attracting quality Once Removed Investors. If you can find this person and get them excited about your deal, do it.

The bottom line on Angels, spend your time looking for solid Relationship Investors or Idea Investors, they are the ones that will get you over the hump. Bring a few Family Investors along for the ride if they won't get sick on the Rollercoaster and hope that you can mix in a good set of Once Removed Investors.

Size of Investment

Next, you have to consider the size of the investment. Money never goes as far as you think it will. My experience is you need to raise between $500K and a $1M to do almost anything. Using Angel Investors to achieve this goal you are likely looking at investments all over the board but usually in the $25K to $100K range. You may have a few smaller and a few larger but in my mind you have to target having no more than 10 to 15 total investors in an Angel round. It's just too hard to herd the cats when the group gets larger than this.

Pre-Money Valuation

A friend of mine with much more experience then myself told me, Angels should get a good deal. They are putting money in at a time when presumably no one else will and they are taking a huge risk. I can't tell you how many people have said, "Yeah, but its only $25K and they have lots of money". That's total bullshit; show me someone who lights $25K on fire for no reason.

Having been on both sides of these kinds of deals, I totally agree that Angel Investing is very high risk and the road ahead as an Angel is fraught with investment disaster. Lots of wonky things can happen to the Angels when VC's come into the company including investment preferences that take away the Angel Chocolaty goodness. I have also, unbelievably, had meetings with entrepreneurs where they are indignant I won't accept their pre-money valuation on their imaginary business. I always tell them the same thing, if my money is so unimportant, do it with yours. If you feel compelled to twist the valuation screws do it in the A round with the professional investors.

Investment Mechanism

There was a period of time where nearly every startup was doing convertible financings. This is where as an Angel you invest as if the investment is a debt type financing but can convert to an equity investment based on some outcome or the will of one party or the other. I tend to think these deals kind of suck. They are usually setup to attract money fast, and often in the case of the entrepreneur are empowering some kind of fantasy that the investment could be paid off based on success of the company and he won't need to give any equity away. As an investor that's the last thing I want because that just turns my investment into a very high risk bank account. The only time I saw this work well was a company that had plenty of investors around the table and incented them to invest early to get the company jump started faster. Early investors got some warrants to make it worth their while to have their money show up to the party sooner (and deal with the risk of being the first money in). Just skip this stuff, get all your Angels aligned, do one close, and make it a pure equity round. If you aren't ready to sell equity in your idea, finance it yourself.

Liquidity

With the exception of possible investors in the Family category, Angels are not in it to finance your dream indefinably. You would not think it to be the case, but I have had several conversations with people approaching me for Angel investments who simply could not articulate how I would ever get any money back. They were so focused on getting money from people they forgot 'they are an investment', and investments have terms. Almost without exception, I don't want to own your dream, I want to make money and have a little fun along the way. If you never sell the company, I never realize a gain.

Conclusion

There are probably 5 more posts I can do on this subject but my goal was simply to put together a primer on this subject. So many people approach me not understanding the dynamics of early stage financing. Brad Feld has written good stuff in this area on his blog as well as some quality stuff on AskTheVC. Use these resources to understand the numbers, but don't forget to understand the motivations.